The recent sharp rise in the value of the yen is complicating the task of the Bank of Japan as it looks to fight deflation and revive economic growth, argues Mary Nicola.


The Bank of Japan (BoJ) has in recent months showed its ability to surprise. In January, just a month after it unexpectedly decided to increase the maturity of the government bonds it buys, its board voted by the slimmest of margins to take the significant step of introducing a negative deposit rate for the first time in its history. Then, on April 28, hopes it would expand its balance sheet further were dashed.

Working out what the BoJ is going to do next is getting difficult. But what is not in doubt is that the way in which the yen has been responding to these surprises is making the central bank’s task ever harder.

The yen has had its best start to a year in more than two decades, surging to an 18-month high against the US dollar. The currency’s 12-per cent gain in the first four months of the year is casting doubt on the central bank’s ability to lift inflation. And perhaps more worrying still, the perverse way in which financial markets reacted to January’s surprise rate cut has raised fears that monetary policy, partly because it may be having unintended consequences, is becoming ineffective.

While the reasons for the yen’s strength can be debated, with much of it no doubt the result of its perceived ‘safe-haven’ status, the bottom line is that the appreciation is stymieing the central bank’s efforts to reflate the economy. That is because one of the ways looser monetary policy is supposed to boost economic growth is by improving a country’s trade balance via a weaker exchange rate. A stronger yen is obviously liable to have the opposite effect. 

BoJ Governor Haruhiko Kuroda continues to talk up the bank’s ability to achieve its inflation mandate by easing policy further. But recent history suggests he is going to be fighting an uphill battle. As the chart below shows, despite persistent efforts the central bank has failed miserably in its efforts to stoke inflation.

Inflation expectations have been declining 

Source: Macrobond, March 2016
CPI – Consumer Prices Index, TW JPY – Trade-weighted value of the yen

Another unwanted side-effect of negative policy rates is the detrimental impact on banks’ profitability. As the chart below shows, these concerns have been weighing on Japanese banks’ share prices.

Negative rates may be punitive for banks

Source: Macrobond, March 2016
Nikkei 500 Bank Index, Nikkei 500 Index

While the BoJ has tried to mitigate this by introducing a tiered set of policy rates, there are concerns that a decline in banking sector profitability will adversely affect the availability of credit. But having opened the door to more negative rates, it may be that the BoJ thinks the negative impact on the banking system is outweighed by the added encouragement to domestic investors to rebalance portfolios towards riskier assets.

We nevertheless expect the BoJ will need to look at other policy options in addition to more negative rates, including possibly larger purchases of equities through exchange-traded funds. Given the detrimental moves in both the yen and domestic share prices, the challenge for the BoJ seems as great as ever.

Weak wage growth casts further doubt on inflation target being met

The result of the first round of the ‘shunto’ spring wage negotiations was disappointing to policymakers hoping to see faster earnings growth. The major car makers and electronics firms agreed smaller hikes in base pay than a year ago. The annual increase fell to 2.08 per cent from 2.43 the previous year. Although companies were more generous with bonus payments and in terms of pay rises to temporary workers, if other firms follow suit, as seems likely, the BoJ will be faced with another headwind in its efforts to lift inflation.

China’s renewed focus on growth and signs that output may be picking up in other large trading nations is good news for the BoJ. We believe a gradual recovery in global risk sentiment and economic growth should enable both inflation and wages to recover. But this is likely to happen only very gradually. And the central bank will have to repeatedly push back the date when it forecasts inflation returning to target as it did at the March meeting.

As for the yen, a stabilisation in commodity prices and delay in US interest rate hikes could revive demand for emerging-market assets funded by negative-yielding currencies such as the yen, or the 'carry trade'. This may do more to weaken the yen and help the BoJ achieve its reflation objectives than further aggressive easing of monetary policy.

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